Long-term bonds fall after Bernanke speaks

Five-year auction, durable goods pushed into background

By

DeborahLevine

NEW YORK (MarketWatch) — Long-term Treasury prices fell Wednesday, pushing yields up from their lowest levels in a month, after the Federal Reserve hiked its forecast for inflation and cut its economic growth view.

At the same time, Fed Chairman Ben Bernanke said during a news conference that he doesn’t know when the central bank will tighten its monetary policy, which kept yields on short-term debt from rising.

He again noted medium-term inflation expectations remain stable and it’s important for policy makers to help support the economic recovery, so the Fed would continue reinvesting maturing Treasury and mortgage-related holdings in its portfolio.

Yields on 10-year notes
TMUBMUSD10Y, +0.00%
which move inversely to prices, rose 4 basis points to 3.36%, after reaching 3.39% just after the release of the Fed’s statement. A basis point is 1/100th of a percent.

Longer-dated debt is most sensitive to inflation expectations, because inflation erodes the value of fixed bond payments. The longer the maturity, the more that’s a potential problem for the bondholder.

Yields on 2-year notes
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which tend to be most sensitive to expectations of the Fed, erased an earlier increase to trade little changed at 0.65%. On Tuesday, they touched their lowest level since late March.

Bernanke’s news conference was the first-ever post-meeting briefing. Earlier, the Federal Reserve concluded its policy meeting and said its bond-purchase program will end on schedule and inflation expectations remain stable. Read story on Fed statement.

“It’s very clear to me that the Fed is in no hurry to really change interest rates significantly any time soon,” said Bill Hornbarger, chief investment strategist at Moneta Group. That will keep bond yields from rising too much, but “outside another severe correction in stocks, it’s hard to conjure up a scenario where yields go a whole lot lower.”

The central bank maintained that the inflation pickup will be temporary and the job market remains a concern, and that it would keep interest rates at a historic low range of 0% to 0.25% for an extended period.

Regarding the end of the bond-purchase program, the centerpiece of the Fed’s loose monetary policy since interest rates have been held near zero, officials said they are prepared to adjust their bond holdings “as needed to best foster maximum employment and price stability,” in a statement.

The buybacks were the Fed’s attempt to keep money flowing through the financial system and to prevent too much of an increase in interest rates, which could slow the economy’s recovery.

The bulk of the purchases have been part of the $600 billion purchase program announced in November, what some analysts call the Fed’s second round of quantitative easing, or QE2.

Besides that, the Fed has been reinvesting cash from maturing mortgage-related holdings back into Treasurys, which have accounted for about $17 billion to $32 billion of the monthly purchases since August.

Under both programs, the Fed has purchased $623 billion in notes and bonds through this week, according to Morgan Stanley.

The Fed has concurrently been reinvesting cash from maturing mortgage-backed securities it bought during the credit crisis, to prevent an inadvertent shrinking of its balance sheet that could act as a modest tightening.

Bernanke said the size of the portfolio matters more than its continued buying, so holding it steady should minimize any effect on markets from the end of so-called QE2. Read more on Fed, Bernanke.

To not continue reinvesting “would be expected to tighten financial conditions,” he said.

The Fed is seen as keeping interest rates on hold into 2012 and the economy is not growing that quickly, which will support bonds, said John Canally, an economist for LPL Financial.

U.S. 10-year yields are likely to stay in a range between 3.50% and 4%, he said. Uncertainty about European debt and Japan will also cap an increase in yields as investors shift into higher-yielding, riskier assets.

Investors were also looking for any comments Bernanke makes about inflation expectations, even though he’s repeatedly said he expects commodity-driven price increases to be transitory.

“The market bears are hoping or expecting that the Fed will do a mea culpa and acknowledge that it’s fueled the commodity inflation thing and, by doing so, presage a move to more removal of accommodation,” said David Ader and Ian Lyngen, strategists at CRT Capital Group, in a note before the news conference. “But the Fed is not like market folks and get emotional over a position but rather dull, dreary and very studied in their policy making.”

“If anything, Bernanke himself is a leading dove, so if there is a skew, it would be more likely to support the Fed’s accommodative stance than emphasize the risks that it’s wrong,” they wrote.

The Fed’s preferred measure of inflation expectations has barely budged this year, still showing investors see inflation of about 3.03% over the long term, according to RBS.

Auction demand

Bonds extended losses slightly after the government’s auction of 5-year notes was met with tepid demand.

The auction was earlier than usual to conclude before the Fed absorbs all of the market’s attention.

Bidders offered to buy 2.77 times the amount of debt sold, right in line with the average at the four most recent auctions.

Indirect bidders, a group that includes foreign central banks, bought 40% of the sale, versus an average of 39.2% of recent sales.

Analysts regard the statistics, though imperfect, as a snapshot of foreign investors’ appetite for U.S. debt. Final figures on what types of investors were buying at the auction take longer to be released.

Direct bidders, a group that includes domestic money managers, purchased another 11.2%, compared to 8.7% on average.

The government received a “lackluster reception to the auction,” said strategists at CRT Capital Group.

The bulk of the remainder goes to primary dealers — private banks and broker-dealers that are required to bid at Treasury auctions — though the Fed does buy a small amount of every auction for its own account.

When a higher proportion of a sale goes to direct and indirect bidders, it’s considered a sign of strong investor demand. Otherwise, primary dealers end up with more of the new debt, and they tend to turn around and sell it, weighing on prices.

On Tuesday, the government received decent demand for its sale of 2-year notes. See more on 2-year auction demand.

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